The life insurance industry and to a larger extent new agents therein are quick to proclaim that life insurance death benefits are always 100% tax free… this is just plain wrong. The sad part, is that those newer agents don’t even know that they are only providing their client’s with half-truths. There are very real, and not completely uncommon, situations where a life insurance death benefit can be taxable.
Life Insurance May be Included in Your Estate for Estate Tax Purposes if You Have Incidents of Ownership
Under IRC Section 2042 Life Insurance Proceeds may be included in your estate. Specifically,
The value of the gross estate shall include the value of all property—
(1) Receivable by the executor
- To the extent of the amount receivable by the executor as insurance under policies on the life of the decedent.
(2) Receivable by other beneficiaries
- To the extent of the amount receivable by all other beneficiaries as insurance under policies on the life of the decedent with respect to which the decedent possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with any other person. For purposes of the preceding sentence, the term “incident of ownership” includes a reversionary interest (whether arising by the express terms of the policy or other instrument or by operation of law) only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent. As used in this paragraph, the term “reversionary interest” includes a possibility that the policy, or the proceeds of the policy, may return to the decedent or his estate, or may be subject to a power of disposition by him. The value of a reversionary interest at any time shall be determined (without regard to the fact of the decedent’s death) by usual methods of valuation, including the use of tables of mortality and actuarial principles, pursuant to regulations prescribed by the Secretary. In determining the value of a possibility that the policy or proceeds thereof may be subject to a power of disposition by the decedent, such possibility shall be valued as if it were a possibility that such policy or proceeds may return to the decedent or his estate. Emphasis added
If you own and control the policy that policy is going to be included in your taxable estate. If we are talking about Federal Estate taxes, this just doesn’t matter that much since only one to two percent of the population will land above the exemption amount, currently at $5,250,000. Notwithstanding the near unattainable Federal Level, a minority of States, often referred to as Decoupled states, may have their own estate tax laws which start at a much lower exemption amount.
For example, in New York you have a taxable estate once you hit the $1,000,000 mark. So if you die owning and controlling assets worth $1,000,000 and then have a life insurance policy worth $1,000,000 the life insurance will be taxable leading to a State Estate Tax of about $99,000 – not a small amount. The rate is graduated and ranges from 7% at the bottom end to over 16% once you hit the top amount.
Life Insurance Death Benefit May be Taxable Pursuant to Transfer for Value
Life insurance does not only affect the taxable estate but can also be included in a beneficiary’s income taxes under a transfer for value situation. Transfer for Value comes up in IRC Section 101, but is interpreted succinctly by Investopedia,
One of the key benefits of any kind of is the tax-free death benefit. However, some speculators began to transfer life insurance policies between parties in order to reap large tax-free windfalls. In order to discourage this, Congress declared that any life insurance policy that is transferred for any kind of material consideration may become partially or fully taxable when the death benefit is paid out. This rule is known as the transfer-for-value rule, and it stands as one of the few exceptions to the general exemption from taxation accorded to all life insurance death benefit proceeds.
The transfer-for-value rule states that once the recipient of a life insurance policy transfers the benefit to another party, the tax exempt status of the policy will be removed and the purchaser will have to pay income tax on a portion of the death benefit. The rule apples if the policy is received in return for valuable consideration of any kind. The amount of death benefit that is not taxed equals the value of the consideration received, plus any subsequent premiums that are paid into the policy by the recipient after the transfer. The rest of the death benefit is fully taxable as ordinary income.
Life insurance is not a normal balance sheet asset it should be handled with care and professionalism. You can’t use it as easily as you’d like as collateral or consideration otherwise you may run into a transfer for value problem.
Life Insurance May End Up Income or Estate Taxable
These are just two examples of how life insurance may be taxable. While both are not every day run of the mill situations they aren’t completely uncommon either.